An American Perspective from China

Don’t Devalue the Renminbi

This op-ed of mine appeared in the South China Morning Post on January 30, 2009.

Risky Business (Don’t Devalue the Renminbi)by Patrick Chovanec

What goes up must come down – at least that’s what China’s exporters are hoping. After a 3½-year run in which the yuan has appreciated more than 20 per cent against the US dollar, Chinese factory owners hit hard by the slowdown in global consumer demand are fervently hoping that their government will reverse course and devalue the yuan, making their goods cheaper and more competitive. It’s a tempting course, but one that China should resist. Devaluing the yuan right now would be bad for business, bad for China and bad for the global economy.

To understand why, one must look at how China’s economic growth strategy over the past decade has affected its balance of payments. That strategy has two elements: first, attract direct and financial investment from abroad to expand and improve capacity, and second, sell the output abroad to maximise both employment and savings at home. It’s the perfect plan to supercharge growth, but it has an inherent contradiction. A country’s current account (in trade) and its capital account (in investment) must balance, or cancel each other out. A US dollar that flows into China must eventually flow out and, if there’s a net inflow of dollars in both trade and investment, there’s nowhere for them to go.

In a completely free market, the relative price of each currency would adjust based on supply and demand until the imbalance was resolved.

Of course, governments can and do intervene to manage exchange rates. Until July 2005, China’s central bank kept the market from bidding up the yuan by buying all the excess US dollars that nobody wanted at a fixed rate of 8.27 yuan to the US dollar. The dollars it bought accumulated as reserves, and China was able to maintain the funding imbalance that fuelled its rapid growth.

There’s nothing inherently unfair or wrong about using currency reserves to maintain a fixed exchange rate, but it’s a short-term solution. Most countries hold reserves either to fund special projects that can only be paid for in hard currency or to weather temporary swings in economic fortune that may dampen export earnings or send capital scurrying abroad. But China’s trade surplus and investment inflows only grew larger with time. The US, alarmed at job losses from outsourcing, began leaning heavily on Beijing to allow the yuan to appreciate. The result was a “managed float” that gradually brought the yuan up to its current rate of 6.84 to the dollar. Even so, the flow imbalances persisted and China’s official reserves continued to climb to a mind-boggling US$1.95 trillion.

Within China, these massive reserves are generally celebrated as a sign of the nation’s economic strength and seen as a “nest egg” to ensure the country’s future needs can be met. American pressure to rein in China’s external surpluses is resented as the actions of an envious bully. In fact, the accumulation of reserves on this scale poses a serious problem, to China more than anyone.

To put it simply, China has more US dollars than it can use and no place to put them. It can’t stop buying more for fear that the yuan’s unrestrained appreciation would cause unemployment and social unrest. It can’t even hint at selling any without putting the US dollar into a tailspin and wiping out its own holdings. It is unwilling to increase demand for dollars by letting Chinese individuals and firms invest privately abroad, for fear that capital will no longer be available to fuel its unrelenting growth.

Beijing’s only realistic option is to buy more and more US Treasury bonds, and it is keenly aware that it is disturbingly exposed to any US move to effectively default on that debt by printing more dollars. And it’s not just Beijing’s problem; in order to avoid domestic inflation from issuing yuan to buy US dollars, the central bank cancels the effect by selling bonds to Chinese citizens. In effect, Chinese savers are the ones holding all these unwanted dollars – hardly cause for celebration.

Which brings us to the present matter of yuan devaluation. In the short run, devaluation is the convenient solution. It seems to give everyone what they want. China gets to keep expanding and exporting at a breakneck pace, and employing its workers. The US gets an inexhaustible pool of captive dollars to fund the wildest deficit spending imaginable, and never has to pay it back (at full value, at least) if it doesn’t want to. But soon, the results would be disastrous.

China’s export-led growth model worked well in the early stages, but is unsustainable now that it has become the third-largest economy in the world. As it stands, Chinese savers are essentially paying American consumers for the privilege of going to work. China is creating wealth but not reaping the reward. A real, lasting solution involves eliminating the imbalances that have led us to this dead end, and has two elements. First, China must unlock domestic demand, not merely for Chinese goods and services, but for imports as well. Second, it must allow its citizens and firms to freely invest privately abroad. Only by committing to a more sustainable growth model can China ensure its continued prosperity.

Devaluing the yuan would move China and the world in the wrong direction, exacerbating China’s balance-of-payments crisis, digging the hole even deeper. And it would almost certainly inflame simmering trade conflicts between the US and China. It is well worth remembering that competitive devaluations, and the retaliatory trade sanctions they triggered, were key factors in deepening and prolonging the Great Depression. History and reason tell us that they are not the answer to today’s challenges.